Will Selloff Push Emerging Market Central Banks to Raise Rates?

Renewed turmoil in emerging markets is raising uncomfortable memories of last summer’s sharp selloff, and may add to pressure on Asian central banks to tighten monetary policy.

India’s central bank raised interest rates again Tuesday to fight inflation — and just as a renewed wave of selling is shaking emerging markets.

Agence France-Presse/Getty Images

In India – one of the countries hardest hit when investors fled emerging markets last summer in anticipation of higher rates back home – the central bank confounded expectations Tuesday by raising rates a quarter-percentage point.

The Reserve Bank of India cited the need to bring inflation to heel, after Gov. Raghuram Rajan suggested he supports a recent recommendation to adopt a strict inflation-targeting regime. But the positive reaction in the rupee and Indian stocks suggests investors see the move as a veiled attempt to keep funds from flowing out of the country again.

Further afield, Turkey’s central bank called an emergency meeting for Tuesday after the lira hit a record low Monday. The currency leaped 5% in Tuesday’s trade.

Those moves also shed fresh light on the Bank of Thailand’s narrow decision last week to hold rates steady. A rate hike was out of the question given Bangkok’s political implosion and the softening economy, but the surprise decision not to cut rates was likely meant to preserve whatever appeal Thai assets still retain. Foreign investors have pulled some $4 billion out of Thai markets since the end of October, according to Mizuho Securities, driving the baht currency down 5%.

Last summer, it was fears of an impending end to a U.S. Federal Reserve stimulus program that had flooded global markets with liquidity that sparked the wide selloff. By the time the Fed ultimately did decide in December to “taper” its bond purchases by $10 billion a month, markets essentially shrugged. A further $10 billion monthly cut is likely to be announced this week.

The latest bout of emerging-market turmoil was sparked by a combination of factors last week, including disappointing growth figures from China and Argentina’s decision to effectively devalue its currency. Few expect a general wave of selling that would mirror last summer’s stampede out of emerging markets.

“Although some currencies have fallen sharply this month, it still does not seem right to talk about a new financial crisis sweeping across all emerging markets,” Capital Economics said in a research note Tuesday. “Emerging markets are an increasingly diverse group, meaning that the vulnerabilities (such as to Fed tapering) that will undermine some may have little or no impact on others.”

Most at risk are countries with large debt loads and a heavy dependence on foreign funding. In Asia, that’s India and Indonesia – just as it was last summer.

Still, authorities in both countries have used the months since the taper selloff to shore up their economies to one degree or another, mitigating the downside now.

“This is not to suggest that either country would be unaffected by a riskoff episode (their fundamentals are still not necessarily in great shape),” Credit Suisse’s Robert Prior-Wandesforde wrote Tuesday of India and Indonesia, “but the extent of the damage for a given shock is likely to be less.”

India has raised rates three times in the past five months and opened up new sectors of the economy to foreign investment. The rupee has fallen much further than its Asian peers over the past few days – down 1.59% through Tuesday afternoon – but it’s well off last summer’s lows.

Bank Indonesia has raised interest rates by a cumulative 1.75 percentage points to bolster the rupiah, fight inflation and choke off imports. The central bank expects the country’s current-account deficit to fall below 3% of gross domestic product in the final quarter of 2013, from a high of 4.4% two quarters earlier.

Yet the rupiah remains close to its record lows, having lost 0.78% in recent days. Asked if India’s rate hike Tuesday will increase the pressure for a similar move in Indonesia, Standard Chartered economist Fauzi Ichsan said simply: “Of course.”

Other Asian countries that saw sharp selloffs last summer, such as Malaysia and the Philippines, also are better positioned this time around. Malaysia in particular has taken advantage of the long build-up to tapering to get its house in order, slashing government subsidies to improve its budget position and staggering capital-intensive imports to keep its trade balance in surplus.

Indeed, the emerging-market currencies that have fallen most in the past few days include those where authorities have a record of economic mismanagement or large current-account deficits, such as Argentina and Turkey. Those losses have few obvious implications for better-run emerging markets.

That marks a sharp contrast from last summer.

“The real lesson from recent events,” Capital Economics said, “is that the need for investors to discriminate between individual emerging markets has never been greater.”